You might have read this quote before. It’s cited a lot. People often use this quote to promote the idea that you should buy a stock and hold forever.

This is particularly true in the dividend community. Investors often hold onto a dividend payer because they are getting “paid to wait.”

What’s often left out is the next sentence which is far more important.

“We are just the opposite of those who hurry to sell and book profits when companies perform well but who tenaciously hang on to businesses that disappoint. Peter Lynch aptly likens such behavior to cutting the flowers and watering the weeds.” — Warren Buffett, 1988 Berkshire Hathaway Letter to Shareholders

This second sentence seems to contradict the first. He’s saying that most investors are quick to take profits on high-flying stocks, while they hang onto losing businesses too long.

In other words, he’s advocating NOT selling a stock just because it’s been doing so well. He’s also advocating TO sell a stock that has been doing poorly.

This is contrary to most of what everyone seems to think about Warren. Doesn’t this guy love to buy stocks after they’ve done poorly?

His IBM purchase and sale is a prime example. In 2018, he sold out completely out of the struggling Technology giant. That is all despite a struggling stock price that many would say was getting “cheaper”.

Why?

Isn’t Buffett a value investor. If he thought it was a value at $200 per share, why wouldn’t it be more of a value at $150?

He realized he made a mistake. The stock was dropping in price, yes, but so was the actual underlying value of the company itself. The market was right to lower IBM’s stock price. So Buffett sold out.

1. Listen to the Market

If one of your stock holdings is dropping in value, don’t assume that it’s “cheap” and “getting cheaper”.

Remember, your dealing with a very smart stock market with millions of highly motivated investors. Most of these have about 100x more resources than you can ever dream of. The thousands of mutual funds and private equity funds have access to armies of highly trained research analysts. Many also have PhD’s looking for any small edge than can get.

In other words, you’re not up against the average Joe.

There is a reason why a stock is plummeting. Don’t be so arrogant to think that you can outsmart the market. If a stock drops 40%, something has changed with the underlying business. The market rarely makes mistakes that big.

Always assume other investors may know something that you don’t. Be quick to reconsider that your original analysis may have been wrong. If you do and remain convinced that its future is as bright as when you bought it, then buy more. Otherwise, keep a close eye on it.

If you become at all concerned about future dividend payments or future growth rates — then cut bait. There’s no shame in that. There are plenty of other fish in the sea.

2. Let Your Winners Win!

Don’t be too quick to take profits. A stock that’s dropped 40% has done so for a reason, but a stock that’s up 40% has also done so for a reason.

It’s easy to assume that you’re “selling high”. However, a company with improving fundamentals may just be getting started. Plenty of research shows that high momentum stocks continue to do well for the next 6-12 months. Don’t sell too soon.

Set a limit on how much of your portfolio a stock should be. In our firm’s portfolios, we say 5% or more is too much. You may be comfortable with 10%. It’s up to you.

Either way, set a limit and stick to it.

But if a stock starts out as a 2% weighting and goes up 50% — don’t cut it just because its up 50%.

3. Businesses Aren’t Stagnant

The competitive environment is always changing. If the company isn’t keeping up, it will (eventually) die regardless of how great it is.

IBM is a great example. GE is probably an even better one. If you buy a company and think you can hold it “forever” because it’s a “great business” today — think again. Businesses change. What is great today may not be great in 5 years.

To conclude, we can all agree with Warren Buffett that “forever” is ideal. In a perfect world, you’ll never have to sell a single stock. Every company in your portfolio will continue to pay and grow their dividends for the next 50 years.

We don’t live in a perfect world. There will be winners and there will be losers. Today’s winners may be losers tomorrow. Or vice versa. Be vigilant.